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Chapter 10
3. Yield
Inventory Management
Cost of maintaining inventory:
1. Carrying costs: all costs associated with carrying
inventory
2. Ordering costs:
Inventory Management
Total inventory maintenance costs (carrying
costs plus ordering costs) vary inversely.
Carrying costs increase with increases in average
inventory levels and therefore argue in favor of low
levels of inventory in order to hold these costs down.
Ordering costs decrease with increases in average
inventory levels and therefore firm wants to carry high
levels of inventory so that it does not have to reorder
inventory as often as it would if it carried low levels of
inventory.
Inventory Management
Economic order quantity (EOQ) model:
mathematical model designed to
determine optimal level of average
inventory that firm should maintain to
minimize sum of carrying costs and
ordering costs (total cost inventory
maintenance cost)
Explains inventory control problem
EOQ = 2FS/CP
Inventory Management
See Exhibit 10.3
EOQ model determines equation of total
cost curve.
Minimum point indicates optimal average
inventory.
Optimal average inventory level dictates
how much inventory should be ordered on
each order to maintain average inventory
level.
Inventory Management
Basic EOQ model assumes that inventory is used up uniformly and
that there are no delivery lags (inventory is delivered instantaneously).
Thus, two modifications:
1.
2.
Ex. If 2,700 units are ordered every 3 months and normal delivery time is one
month after order is placed, then EOQ should be ordered when on-hand
amount drops to 900 units.
Add quantity of safety stock to base average inventory that allows for
uncertainty of estimates used in model and possibility of non-uniform
usage.
Ex. Adequate level of safety stock is 500 units. Reorder point would be
increased to 1,400 units (900+500) and new order would be placed
each time on-hand quantity reached 1,400.
Inventory Management
Example: Widget Wholesalers, Inc.
Inventory Management
EOQ model can be applied to current
asset management.
EOQ can also be used to manage other
types of inventories, such as cash and
accounts receivable.
Cost of maintaining these assets can be
divided into ordering and carrying costs,
and optimal assets levels can be determined.
Sources of Short-term
Financing
Three major sources of short-term
financing:
1. Trade credit (accounts payable)
2. Commercial bank loans
3. Commercial paper
Sources of Short-term
Financing
1. Trade credit (spontaneous financing): form of free
financing in the sense that no explicit interest rate is
charged on outstanding accounts payable
Sources of Short-term
Financing
2. Commercial bank loans
Sources of Short-term
Financing
At end of note term (maturity date), face amount of note must be repaid or
note must be renewed (rolled over).
Bank and borrower may enter into formal/informal agreement to renew note
at maturity at specified rate, which is tied to prime interest rate (rate
charged to banks best corporate customers).
o
Ex. Interest rate at prime plus some percentage over prime: prime plus
2%
Size of premium above interest rate is determined by banks assessment of
risk involved in making loan
o
Higher risk, higher premium
As prime rate changes, banks cost of obtaining funds changes, so requiring
firm to roll over its notes allows bank to change interest rate on note.
Sources of Short-term
Financing
2. Commercial bank loans (continued)
Two possible structures
2. Line of credit (revolver)
Sources of Short-term
Financing
Sources of Short-term
Financing
3. Commercial paper (recall Chapter 9):
short-term corporate IOU that is sold in
large dollar amounts through commercial
paper dealers
Sold by large corporations
Usually purchased by other corporations (as an outlet
for marketable securities) or by financial institutions
(i.e. banks, money market mutual funds)
Not available means of financing for small business
organizations
Sources of Short-term
Financing
Financing Accounts Receivable
Accounts receivable: used as collateral
for short-term loans
Three methods of accounts receivable
financing:
1. Pledging
2. Assigning
3. Factoring
Sources of Short-term
Financing
Financing Accounts Receivable
1. Pledging
Sources of Short-term
Financing
Financing Accounts Receivable
2. Assigning
Sources of Short-term
Financing
Financing Accounts Receivable
Pledging/Assigning (continued)
Lender has recourse to borrower if account
fails to pay
Lender only acts as supplier of funds so if
borrower defaults, borrower suffers bad-debt
loss, not lender
Cost of pledging and assigning are about
equal
Sources of Short-term
Financing
Financing Accounts Receivable
3.Factoring
Lender buys accounts receivable outright
from borrower at discount from face value
and assumes burden of collecting
receivables
Sources of Short-term
Financing
Financing Accounts Receivable
3.Factoring (continued)
Lenders provides three services
1. Provide financing of accounts receivable for
borrowing firms
2. Act as borrowing firms credit department
3. Assumes risk of bad-debt losses
Sources of Short-term
Financing
Inventory Financing
Commonly arranged through:
1. Blanket liens
2. Trust receipts
3. Field-warehousing arrangements
Sources of Short-term
Financing
Inventory Financing
1.Blanket lien
Firm pledges its inventory as collateral for
short-term loan, but lender has no physical
control over inventory
If borrower defaults, lender has right to seize
inventory and sell it to pay off loan principal
and interest; any funds realized in excess of
amount owed must be returned to borrower
Sources of Short-term
Financing
Inventory Financing
2.Trust receipt
Legal document that creates lien on specific item of
inventory
Commonly arranged for big ticket items (i.e. inventory
held by automobile dealers, jewelers, or heavy equipment
dealers
When item is sold, amount loaned against item must be
remitted to lender
Sources of Short-term
Financing
Inventory Financing
3. Field-warehousing arrangement